Is Hedge Accounting Designation Informative About How Firms Use Derivatives?

Abstract

Firms use derivatives for a variety of purposes including hedging, speculating, meeting or beating benchmarks, and smoothing earnings. However, poor disclosures have made it difficult for the investors to identify the motives behind and the economic consequences of firms’ derivative use. We use the derivative disclosures required by SFAS 161 to examine whether the economic consequences and investors’ reactions to derivative use vary by the accounting designation firms use for their derivatives. We find that hedge designated derivatives are negatively associated with several measures of firm risk, suggesting that the accounting designation of these derivatives captures the intended economic use of these derivatives. However, while the majority of firms in our sample claim to use non-hedge designated derivatives only for hedging purposes, we find that such non-hedge designated derivatives are positively associated with several risk measures. We also find that investors price derivative gains differently depending on the derivative’s accounting designation. Overall, the results suggest that the accounting designation for derivatives is informative to investors as to how firms use derivatives.

Keywords: derivatives, hedging, SFAS 161

JEL Classification: M41